I'm a Fellow at the Adam Smith Institute in London, a writer here and there on this and that and strangely, one of the global experts on the metal scandium, one of the rare earths. An odd thing to be but someone does have to be such and in this flavour of our universe I am. I have written for The Times, Daily Telegraph, Express, Independent, City AM, Wall Street Journal, Philadelphia Inquirer and online for the ASI, IEA, Social Affairs Unit, Spectator, The Guardian, The Register and Techcentralstation. I've also ghosted pieces for several UK politicians in many of the UK papers, including the Daily Sport.

Explaining The Secret Of Warren Buffett's Success: Double Leverage

The Economist has a nice piece detailing a good half of Warren Buffett’s incredible investment success over the past 50 years. It is, as I have long maintained, because he is running an insurance company. Yes, he’s clearly a great investor, there’s no doubt about that. But his outperformance comes from his being able to finance his investments from within the premium pool of those insurance companies:

Without leverage, however, Mr Buffett’s returns would have been unspectacular. The researchers estimate that Berkshire, on average, leveraged its capital by 60%, significantly boosting the company’s return. Better still, the firm has been able to borrow at a low cost; its debt was AAA-rated from 1989 to 2009.

Yet the underappreciated element of Berkshire’s leverage are its insurance and reinsurance operations, which provide more than a third of its funding. An insurance company takes in premiums upfront and pays out claims later on; it is, in effect, borrowing from its policyholders. This would be an expensive strategy if the company undercharged for the risks it was taking. But thanks to the profitability of its insurance operations, Berkshire’s borrowing costs from this source have averaged 2.2%, more than three percentage points below the average short-term financing cost of the American government over the same period.

If you can borrow below market and make only market returns then you’re going to outperform the market in your returns on equity.

And this really is the great big secret about insurance companies. To some extent they’re really just large investment funds that happens to run insurance premiums through their books. It depends which specific insurance market you’re in but you might get to hang on to those premiums for a few months or a few years. And the real profit in the business (to the point that it’s not unusual at all to see an insurance company making a loss on the actual insurance and underwriting side of the business) comes from the performance of that investment fund. By the time you get to being a reinsurance company (which Berkshire Hathaway also is) you might hang on to the premiums for a decade or more. Making the performance of the investments really just about the only thing that matters to the company.

That’s one form of leverage that Buffett has used. The other is that he went and bought an insurance company or three in the first place. He made good money as an investor first, yes, he very much did. Which he then used to purchase his way into the insurance business. He then applied his investment technique, as the Economist describes it, to the much larger investment funds that the insurance company controlled. Those funds being a good multiple of the funds that it had cost to purchase the company.

Imagine, just as a made up numerical example, that Buffett outperformed the market every single year by 1%. Another made up number, he started with $1 million. He’s going to, over the decades, make himself a very rich man that way. But look at it this way: if he uses the $1 million to purchase control of an insurance company with $10 million to invest, then he gets that 1% outperformance on that $10 million, then he’s going to be making himself richer ten times faster than by not leveraging up by buying the insurance company. For of course the outperformance in the investments flows to those who own the insurance company.

As I say, these are entirely made up numbers. But the basic point is true. Buffett’s superb investment record obviously and clearly depends upon making the right investments at the right time. But it’s also been hugely helped by that double leverage. Borrowing by the company itself and being able to fund investments at less than market cost. Then the second level of leverage, the very purchase of the insurance companies in the first place. It’s been a stunning performance over the decades, most certainly. But the sheer size of it has indeed been based on those two pieces of leverage.

Post Your Comment

Post Your Reply

Forbes writers have the ability to call out member comments they find particularly interesting. Called-out comments are highlighted across the Forbes network. You'll be notified if your comment is called out.